Supply and Demand Made Easy

Extreme Supply Cases Two extreme supply curves help to illustrate how production costs and prices combine to determine the quantity that will be supplied at any particular price. I’ve illustrated these two cases on the next slide. The graph on the left shows a vertical supply curve and illustrates what economists call perfectly inelastic supply. The graph on the right with a horizontal supply curve illustrates what economists call perfectly elastic supply.

Extreme Supply Cases

Perfectly Inelastic Supply The left graph on the previous slide illustrates a situation in which the price has no effect on the quantity supplied. As you can see in the graph, no matter how low or high the price, the quantity is supplied. Because the quantity supplied is completely unresponsive to the price, it is said to be perfectly inelastic, and supply situations that look like this are usually referred to as situations of perfectly inelastic supply.

Perfectly Inelastic Supply Curious about what things have inelastic supply? The answer is unique things that cannot be reproduced. Examples include: The Hope Diamond: Because it is one of a kind – there’d still be only one Hope Diamond, no matter how much anyone wanted to pay. Land: As comedian Will Rogers said back in the early 20th century, “Buy land. They ain’t making more of it.” (well, except the Dutch) The electromagnetic spectrum: There’s only one set of radio frequencies, and everyone has to share it.

Perfectly Inelastic Supply An interesting thing about such situations is that there are no production costs. Because of this, offering the owner a price is not an incentive in the way it is when you pay a producer enough to make something for you. Rather, the price serves solely to transfer the right of ownership and usage from one person to another.

Perfectly Inelastic Supply Historically, the fact that the quantity of land supplied has nothing to do with production costs has been the justification for property taxes. The way governments see it, they can tax land as harshly as they want because there’s not need to worry that the amount of land – and consequently, the tax base – will ever decrease.

Perfectly Elastic Supply The right hand graph from a few slides back illustrates the case where the supply curve is perfectly horizontal. The idea here is that the supplier is producing something that has nonincreasing cost. No matter how many units you want her to produce, it only costs her X number of dollars to make a unit. There aren’t really any of these in the real world.

Bringing Supply and Demand Together Now it’s time to bring supply and demand curves together so they can interact. First up is the market equilibrium point, where the supply and demand curves cross – in that discussion, I show you how markets determine the amounts, as well as the prices, of goods and services sold.

Market Equilibrium: Seeking a Balance Supply and demand curves are especially useful when you graph them on the same axes. In a few slides, I have drawn a supply curve and a demand curve and labeled them S and D respectively.

Market Equilibrium: Seeking a Balance The point where the supply and demand curves cross marks how much the good or service in question costs and how much of it gets sold. Just remember: X marks the spot! This price and quantity are known as the market price and the market quantity.

Market Equilibrium: Seeking a Balance On the previous slide, I label the market price and market quantity as P* and Q* respectively. What makes this price and this quantity special is that at price P*, the quantity that buyers demand is equal to the quantity that producers want to supply.

Market Equilibrium: Seeking a Balance Start at price P* and move to the right along the dashed line. You can see that buyers demand Q* at that price and sellers supply Q* at that price. Because quantity demanded equals quantity supplied, both producers and consumers are content. The consumers get exactly the quantity that they want to buy at price P*, and the producers sell exactly the same quantity that they want to sell at price P*.

Market Equilibrium: Seeking a Balance With everyone getting what they want, nobody is going to cause any changes. Economists call situations like these, where everybody is happy, equilibriums.

Market Equilibrium: Seeking a Balance At any price besides the market price, P*, there is always some sort of pressure from either buyers or sellers to bring the model back to the market equilibrium price and quantity. The pleasant result is that no matter where the market starts, it always ends back at equilibrium – market forces will always push the price and quantity back to these values. Consequently, the market price and market quantity are also called the equilibrium price and the equilibrium quantity.

Demonstrating the Stability of the Market Equilibrium The market equilibrium is called a stable equilibrium because no matter where the demand and supply model starts off, it always gravitates back to market equilibrium. This is very nice because it means that markets are self-correcting, and if you know where the demand and supply curves are, you know where prices and quantities will end up. Especially gratifying is the fact that the actions of the market participants – buyers and sellers – move the market towards equilibrium without the need of any outside intervention, such as government regulations.

Excess Supply On the previous slide, you can see what happens when you have a price like P2 that starts out higher than the market equilibrium price, P*. At price P2, the quantity demanded by buyers, QD, is less than the quantity supplied by sellers, QS Economists refer to such a situation as an excess supply or a surplus. A situation of excess supply can’t be an equilibrium because sellers aren’t able to sell everything they want to sell at price P2.

Excess Supply In fact, of the total amount that sellers want to sell, QS, only the amount QD is sold, meaning that the remaining amount, QS – QD, remains unsold unless something is done. Well, something is done. Sellers see the huge piles of unsold goods and do what any store does when it can’t sell something at current prices: They have a sale.

Excess Supply Sellers lower the price and keep lowering it until supply no longer exceeds demand. You can see from the graph on the next slide (and a few slides back) that this means sellers keep lowering the price until it falls all the way down to P*, because that’s the only price at which the quantity demanded by buyers equals the quantity that sellers want to supply.

Excess Demand The previous slide shows a situation in which the initial price, P1, is lower than the market equilibrium price, P*. You can see that in this case, the problem is not excess supply but rather excess demand because at price P1, the amount that buyers want to buy, QD, exceeds the amount that suppliers want to sell, QS.

Excess Demand In other words, there is a shortage of QD – QS. As a result, buyers start bidding the price up, competing against each other for the insufficient amount of the good.

Excess Demand As long as the price is less than P*, some degree of shortage exists, and the price continues to be bid up. This means that whenever you start out with a price less than P*, the price is pushed back up to P*, returning the market to its equilibrium – the only place where there is neither a shortage nor an excess supply.